Low volatility, correlations, and other confounding market riddles

If you look at the U.S. stock market in a certain way, most of the trading action in 2017 makes sense. The labor market is strong, corporate earnings are improving, and there’s a chance that business-friendly tax changes will be enacted—all obvious positives fueling a market that’s been hitting record after record.

Looked at in another light, however, and there’s a lot about this market that makes no sense at all.

Vincent Deluard, head of global macro strategy at INTL FCStone Financial, looked at what he called four big discrepancies in the global markets, or trends that made little sense given the economic environment.

The first issue he considered was the lack of volatility in the market. The CBOE Volatility index
VIX, +20.38%
is currently below 10, less than half its long-term average of 20. While it has steadily traded under that average for years, the lack of swings has been particularly acute of late. The VIX recently neared its lowest level ever, and recent trading has been among the quietest in history.

Most investors have questioned the lack of volatility in light of the fact that equity valuations are high and there is a heavy dose of political uncertainty in the world, starting with the tense standoff between the U.S. and North Korea. Deluard, however, looked at it within the context of rising interest rates.

“For every financial asset, the relation between price and discount rate is convex, which means that prices rise to infinity when rates approach zero,” he wrote in a report. “The logical conclusion is that volatility should soar as central bankers slowly normalize monetary conditions after an extended period of zero (or negative) interest rate policy.”

He added that changes in short-term rates “seem to be completely ignored by long-term Treasurys,” and that because “financial assets are discounted with long-term rates, the apathy of the long-term Treasury market is propagated to the equity market.”

The second issue he looked at was the drop in correlations in the stock market, which has occurred at a time of massive adoption of index funds, particularly exchange-traded funds. In such passive products, an investor essentially buys the entire index, holding every security the index does, and in the same proportion. While some have charged that this would make the market inefficient, as investors would be buying all stocks at the same time, regardless of their fundamentals, that drop in correlations suggests that has not been the case.

Currently, the correlation between the median S&P 500 stock and the index
SPX, -1.42%
itself is 38%, a 10-year low.

“As investors switch into passive index funds and quant strategies, correlations should have risen, as they had during the first phase of the ETF craze,” he wrote. “My only explanation for the recent fall of correlation would be sentiment and investor complacency—the terms strategists use to describe developments they do not understand. Investors seem to be ignoring global geopolitical risk, and focusing only on stock-specific developments.”

“At some point, macro risk will matter again, and its impact on volatility will be magnified by the growing share of index funds,” Deluard wrote. “After more than seven years of ‘lean cows’ for value managers, stock pickers, and equity hedge funds, who will be left to buy when the index crowd sells? ‘Correlations of 1.0’ will become the norm again.”

Deluard’s third market mystery is that he sees European stocks trading at a growing discount compared with the U.S., even though Europe enjoys “a perfect alignment” of macroeconomic conditions, including accelerated growth, cheaper valuations, and an undervalued currency. He calculated that this couldn’t even be explained given the different sector makeups of the two regions.

“The eurozone discount would seem to indicate that the market expects that the European economic cycle is approaching a top, and that earnings growth will slow. Yet, the bond market is sending the opposite message: the German yield curve keeps steepening, and the spread between 10-year and 2-year Treasurys is now wider in Germany than it is in the U.S.” He speculated that the market’s “refusal” to price in a recovery in Europe “argues for a long, unhedged position in eurozone stocks against U.S. stocks.”

Finally, Deluard looked at the relationship between oil prices and the stock prices of exploration and production stocks, which he suggested should have been impacted by fracking, a technology that—along with other factors—contributed to more supply, and thus lower prices, for oil in recent years.

If fracking has had a lasting impact on oil prices, making them “lower for longer,” then “we would have observed a flattening of the historical relation between the two variables: E&P stocks should have been able to maintain their profitability throughout the decline of oil prices.”

This has not proved to be the case; correlations between the two has remained strong. “This disconnect can be solved in two ways,” he speculated. “Either break-even costs have truly fallen and E&P stocks’ will confound the new era of low oil prices with bountiful earnings, or production will fall, eventually leading to higher oil prices.”

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